Why traditional diversification is ‘downright dangerous’

For nearly 70 years, many investors and investment advisors used a basic formula to guide them in creating diversified portfolios: the 60/40 (60 percent/40 percent) stock/bond split.

The strategy worked well: It returned 10 percent a year from 1990–2011.

The question now—as the number of asset classes and strategies available cheaply to investors proliferates, and the risk of holding U.S. bonds rises—is whether the classic 60/40 portfolio split has outlived its investment usefulness and, if so, what should replace it?

For all practical purposes, the short answer is yes, according to Burt Malkiel, Wealthfront chief investment officer, Princeton professor and author of the investment classic, "A Random Walk Down Wall Street," a book that helped launch the low-cost index-investing revolution.

Leland Bobbe | Image Bank | Getty Images

Malkiel recently told CNBC that the 60/40 rule was an oversimplification from the beginning. Now he thinks it is downright dangerous. "The investor in bonds is, I think, very likely to get badly hurt by sticking with the 60/40."

Malkiel has a new recommendation for investors, but it is not as appealingly simple as the 60/40 split. Too bad, he said. "I never have liked any kind of norm."

Weaning people off the 60/40 concept is a challenge, however, precisely because it has worked in the past.

Andrew Ang, the Ann F. Kaplan Professor of Business at Columbia Business School, called the 60/40 rule a shorthand for the concept of diversification. It has been embedded in the investing mind-set since 1952, when Harry Markowitz introduced Modern Portfolio Theory. But in the '50s, there were only two asset classes available cheaply—stocks and bonds, Ang said.

A random walk down dead ends in diversificationWhy 60/40 came to be the norm rather than some other ratio is anybody's guess. Humans seem intuitively drawn to two-thirds, which is also used to represent balance in art and politics. "You'll get similar results doing 50/50 or even 70/30," said Ang, who, like Malkiel, believes that the plain vanilla portfolio is dead in an increasingly complex world.

Any norm at all ignores another fundamental investing precept—that your allocation needs to change to suit your personality and stage of life—a more important concept now than 70 years ago, because people live longer and plan their own retirements.

Investors who let go of oversimplification and embrace a slightly more complex but still low-cost portfolio will be better prepared to meet changes in their lives and the economy, Malkiel said.

(The following is an edited version of an interview CNBC recently conducted with the investing guru on the topic of portfolio diversification.)

"I never have liked any kind of norm. ... The investor in bonds is, I think, very likely to get badly hurt by sticking with the 60/40."-Burt Malkiel, Wealthfront chief investor officer, Princeton professor and author of "A Random Walk Down Wall Street"

CNBC: Why did we ever get the 60/40 in the first place?

Malkiel: I don't know. And I don't like any kind of norm, because it depends on so many factors—and your personality.

The correct allocation ought to depend on individual circumstances. It is definitely not the right kind of thing for everybody. What I had in my "Random Walk" for the last several editions is a quite different allocation. You should have more equity orientation. Another rule of thumb: Jack Bogle has often said bonds should be a percentage equal to your age. I don't agree with that, either.

I think that allocation is particularly wrong today because we are in an age of financial repression. ... Europe and Japan are having trouble reining in budget deficits, and we have high debt in the U.S., too. (The governments) are deliberately keeping interest rates down. Even a U.S. bond index fund is not the right thing to do, because BND [Vanguard Total Bond Market ETF] is about two-thirds government or agency bonds.

The investor in bonds is, I think, very likely to get badly hurt by sticking with the 60/40.

CNBC: In the recent editions of "Random Walk," you suggested the following portfolio for an investor in his or her 50s—with each asset class represented by a low-cost fund—and for the percentage allocated to equities to be larger, depending on the age and risk tolerance of the investor:

Cash: 5 percent

Bonds: 27.5 percent

REITs: 12.5 percent

Stocks: 55 percent

How would you update that portfolio?

Malkiel: The recent editions were written when bonds had a generous yield. Today BND yields are about 2.4 percent. That is why we suggest the bond (safer) part of the portfolio be fine-tuned. We ... use high-quality dividend growth stocks for a part of what otherwise would be a straight bond portfolio. Also, we use some foreign bonds where debt/GDP is low and yields are relatively high.

The updated portfolio for an investor in his or her 50s would look like:

Malkiel: There are so many more asset classes now. It's not that we want to say absolutely never any bonds.

CNBC: How has your view of asset allocation changed over the years?

Malkiel: I'm more open to the idea that you need stability. You may not, as an individual, just be psychologically able to stand the amount of volatility that equities have. You want a little more stability. ... I can understand that. It depends on your ability to not go crazy and sell at the wrong time when the equities drop, as they do.

I'd like to broaden the definition of how you get the stability. It's just saying ... in today's world, bonds as the only possibility to add stability to a portfolio is a much too narrow way to look at it, and a suboptimal way.

We're talking about a broader definition of diversification. There are some financial advisors using this window to broaden it to include a lot of alternative asset classes, like gold.

Some are even suggesting hedge funds. I believe in wider diversification, but for me wider diversification would be to look at some emerging markets that are very unpopular. Or REITs. Real estate is a hard asset, good when inflation is low.

Something like a hedge fund that charges the classic "2 and 20"—2 percent management fee and 20 percent of the fund's profits—is a sure loser.

I'm not a big fan of gold. People say it's a hedge against Armageddon. If the world disappears, your asset allocation will be the least of your concerns.

CNBC: What are the criteria you use to judge an asset class?

Malkiel: You want to control the things you can control. Worry very much about the costs you pay. All of us who deal with the stock market need to be very modest about our ability to make money. But the one thing is certain: The lower the fee I pay ... the more there will be for other investments. Worry about taxes on an asset class, fees, and you do want to be diversified. It's a totally reasonable thing to want stability, but it is not clear to me that that means bonds—or U.S. bonds, specifically.

—By Elizabeth MacBride, Special to CNBC.com

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